We’ve all seen the headlines. In recent days we’ve read in The New York Times: “The Virus Turns Midtown Into a Ghost Town…” In The Wall Street Journal, it was “Google to Keep Employees Home Until Summer 2021 Amid Coronavirus Pandemic.”
Meanwhile, studies are coming out right and left, like one from the non-profit Partnership for New York City that found that one fourth of New York’s office employers plan on reducing their office footprint by 20% or more.
Commercial office real estate is clearly in the throes of a massive disruption, raising serious questions about how and where office space will be occupied in the future. Some of these questions are short term in nature, such as how to construct safe back-to-office programs at a time when COVID-19 has yet to be contained. Other questions will take longer to figure out, and the answers to them will have a marked impact on the business. These include:
- Will work-from-home arrangements be permanent and more widely adopted by companies, resulting in the need to accommodate fewer employees in offices?
- Will companies revert to more space per employee, resulting in a net increase in office space needs?
- Will companies seek out office solutions which provide greater flexibility, e.g. co-working spaces, where they can benefit from certain services but are not required to sign long-term leases? And would this search for flexibility result in more subletting activity, which could improve occupancy but lower rents?
- Will companies shift towards a hub and spoke model, reducing large concentrations of employees in dense urban cores by distributing some of their occupied area to satellite locations in suburban locations, particularly in secondary, more affordable markets, like Atlanta, Charlotte, Denver, Nashville?
As these questions illustrate, the outlook for the office sector remains murky. There are many unknowns in how COVID-19 is going to change the way in which people work and Corporate America is slogging its way through a recession while, in real time, trying to assess what it all means for their business models.
For investors in the office space, the persistent uncertainty mandates caution as it is far from clear who the winners and losers will be. But, critically, as is the case during most periods of market disruption, opportunities will likely emerge for those who are ready, especially as we begin to get clarity about what the post-COVID-19 world will be like.
Amid the turmoil, some office building data points are promising. For example, many office properties have so far managed to weather the economic storm; many landlords have tenants locked in with long-term leases. Further, those tenants, by and large, are still paying rent. In addition, speculative development has become - and should continue to be - hard or impossible to finance, keeping new supply in check. And, not all the reports and studies are glum: 80% of respondents in a mid-July study conducted by the Federal Reserve Bank of Atlanta said they don’t plan on changing their floor space needs, indicating that demand may fall, but not precipitously.
Three Investment Factors for Office
With a strong dose of caution, we’ve been conducting due diligence on a variety of office building properties to better understand how the market is pricing risk in the sector and what the future for demand could be. We look at three determining factors that all have a bearing on how office properties will respond coming out of COVID-19, forming the basis of how we approach investing in the sector.
Not all markets are the same - the shift to suburban markets and secondary markets should continue
Some markets have more to offer than others. Over the past few years, we have seen the vacancy rates for suburban office properties fall and converge with those for central business districts (CBD), which have been lower for the recent past. We anticipate this trend is likely to continue as companies redistribute space away from urban cores. This may also favor high-growth markets outside of traditional high-cost coastal markets like the Bay Area and New York City, representing relatively more affordable options for accommodating a more distributed workforce. Within these markets, submarkets that enjoy greatest ease of access via major transportation routes and have amenities that tenants value will likely outperform other submarkets.
Properties vary in quality too - expect a flight to quality
In a market environment like the present one, Class A properties - top tier, highest quality facilities - are likely to outperform. These buildings are often better amenitized, making them more appealing to tenants. Importantly, we would expect them to be more easily adapted to the physical and operational best-practices required to accommodate post-COVID-19, back-to-office work arrangements.
Discerning scrutiny of rent rolls is critical
This is not a time to be taking near-term leasing risk and therefore, buildings with high-quality tenancy with few leases expiring in the next several years should prove to be more attractive to investors and we believe has already proven to be more attractive to lenders, as financing for these types of properties are available whereas the others not so much as of yet, leading to a big value gap. While few business sectors have been unscathed by the economic downturn, some have obviously been more severely impacted than others. Companies whose primary business is in retail, travel & leisure, and energy, for example, have disproportionately suffered and face a very uncertain recovery. Other tenants have been and should continue to be more resilient in the COVID-19 environment, notably those in healthcare, life sciences, and biotech as well as those in business sectors that have also proven to be pandemic resistant, including consumer goods, logistics, and e-commerce. In short, diligence in understanding the creditworthiness of tenants and the sustainability of their business models has never been more important.
While these themes are highly relevant to investing in the current environment, they have been fundamental to our approach to investing to date and an important lens through which we view our current portfolio. The following office properties in the Cadre portfolio illustrate how these issues come to life in the current environment and how the Cadre team is approaching the challenges:
Class A office in Southern California suburb
- Purchased in Q2 2018 due to its location in a strong submarket, attractive cost basis (purchased at a more than 30% discount to replacement cost), and opportunity to add value through lease-up of vacant space.
- The property now enjoys strong stable occupancy at over 90%, with the lease-up strategy having been successfully executed.
- Post-COVID-19, rent collections have remained strong, registering close to 100% in the most recent months of June and July thanks to high tenant credit quality.
- Of potential risk, the largest tenant (22% of total space) is an online university that conducts a portion of their classes in-person within this building, something that no longer appears to be mission critical for their business. Though their lease doesn’t expire until 2024, there are now questions about the amount of space they will want to occupy and the probability that they will renew when their lease expires.
Class A office in Dallas suburb
- Purchased in Q4 2019 due to its excellent location in north Dallas and opportunity to add value through lease-up of the vacant space and rolling of below-market rents to market.
- Although occupancy is healthy at close to 90%, the original business plan contemplated spending additional capital to push up rents. We are revisiting the timeline of this capital plan in light of the current environment.
- Post-COVID-19 rent collections have averaged approximately 100% thanks to the diversified mix of high quality tenants and industry exposures (financial services, legal services, real estate, engineering, architecture).
- Of potential risk, the largest tenant is a health club (14% of total space, less than 10% of total revenue). While they have reopened their facility and continue to pay their rent, there have been other instances where health clubs have struggled financially and in some cases filed bankruptcy. We are therefore monitoring this tenant closely, though this is one of the strongest locations in their portfolio, with relatively affordable rent, which has allowed them to stay current on rent.
Class A office in Boston suburb
- Purchased in Q1 2019 given the attractiveness of this suburban Boston submarket, which serves as an affordable alternative to downtown Boston, with excellent access to executive housing.
- Current occupancy is 95%, with approximately two-thirds of the space leased to tenants in the life sciences and healthcare industries.
- Post-COVID-19 rent collections have come under pressure, averaging 82% over the most recent months, mostly due to the second largest tenant in the building (21% of total space), who is in the travel and leisure space.
- Of potential risk is the business outlook for our second largest tenant, noted above. Though the tenant appears to be well capitalized, their business has fallen off materially following the downturn of the entire travel and leisure sector. As a result, we are considering a potential restructuring of their lease to defer current rent obligations to the future.
It’s a Stockpicker's Market
Whether as an investor in new opportunities or as an asset manager of existing office buildings, similar themes stand out as critical for success. Because of the forces creating uncertainty about the outlook for demand - both aggregate demand, the location of demand, and the manner in which space planning may change - it is not an environment where a broad macro bet should be made about the performance of the sector. Rather, an approach that takes a critical eye to the factors identified above - market selection, building quality, and quality of cash flow - is most likely to ultimately drive success in investing in office properties.
The views expressed above are presented only for educational and informational purposes and are subject to change in the future. No specific securities or services are being promoted or offered herein.
This communication is not to be construed as investment, tax, or legal advice in relation to the relevant subject matter; investors must seek their own legal or other professional advice.
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Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections are not guaranteed and may not reflect actual future performance.
Risk of Loss
All securities involve a high degree of risk and may result in partial or total loss of your investment.
Liquidity Not Guaranteed
Investments offered by Cadre are illiquid and there is never any guarantee that you will be able to exit your investments on the Secondary Market or at what price an exit (if any) will be achieved.
Not a Public Exchange
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Opportunity Zones Disclosure
Any discussion regarding “Opportunity Zones” — including the viability of recycling proceeds from a sale or buyout — is based on advice received regarding the interpretation of provisions of the Tax Cut and Jobs Act of 2017 (the “Jobs Act”) and relevant guidances, including, among other things, two sets of proposed regulations and the final regulations issued by the IRS and Treasury Department in December of 2019. A number of unanswered questions still exist and various uncertainties remain as to the interpretation of the Jobs Act and the rules related to Opportunity Zones investments. We cannot predict what impact, if any, additional guidance, including future legislation, administrative rulings, or court decisions will have and there is risk that any investment marketed as an Opportunity Zone investment will not qualify for, and investors will not realize the benefits they expect from, an Opportunity Zone investment. We also cannot guarantee any specific benefit or outcome of any investment made in reliance upon the above.
Cadre makes no representations, express or implied, regarding the accuracy or completeness of this information, and the reader accepts all risks in relying on the above information for any purpose whatsoever. Any actual transactions described herein are for illustrative purposes only and, unless otherwise stated in the presentation, are presented as of underwriting and may not be indicative of actual performance. Transactions presented may have been selected based on a number of factors such as asset type, geography, or transaction date, among others. Certain information presented or relied upon in this presentation may have been obtained from third-party sources believed to be reliable, however, we do not guarantee the accuracy, completeness or fairness of the information presented.